CONTROLLING THE MONEY SUPPLY Money, Banking, and the Federal Reserve

What is money? Money: anything that society generally accepts in payment for a good or service.  Very broad definition (beads, clamshells, IOUs, cigarettes in prison, etc.)

What should be included in our calculation of “the money supply” What does our society accept as payment for a good or service?  Currency  Checks (will this be true in 10 years?)  Debit cards  Travelers’ checks *This definition of money is referred to as M1 and totals somewhere around $1.4 trillion. (M2 includes all of M1 plus savings accounts and certificates of deposit (CDs)).

What gives your money value? What’s the difference between a piece of paper and a dollar? Fiat money: the currency used has nothing standing behind them except the fact that they are legal tender (not gold, silver, etc.) Supply of money not tied to holding some other valuable good. Most countries use fiat money.

Fiat Money v. Gold Standard From 1873 to 1933, the US was on some form of the gold standard. The money was backed by gold or a combination of gold and silver.

Pros and Cons of the Gold Standard Advantages? The advantage of such a system is that the supply of money remains limited because the supply of gold is limited. Problems? This type of system can be too confining when an increase in the supply of money is warranted and there is not an increase in the supply of gold held by the government.

Pros and Cons of the Fiat System Advantages? A fiat monetary system is more flexible in that the gold holdings of the government need not increase in order to expand the nation’s supply of money. Potential problems? On the other hand, nations that do not keep the supply of their fiat currency limited will see it diminish in value (sometimes to the point of becoming worthless.)

Zimbabwe Hyperinflation example!!!

The Federal Reserve System (Fed) To understand how the money supply can be changed, it is necessary to understand the Fed. The Fed is the central bank of the United States, which means that it controls the money supply and supervises all the depository institutions in the country (banks, savings and loans, credit unions, etc.)

The Fed The Fed operates as the bank of banks.  E.g. If you need a loan, you might go to a bank. If a bank needs a loan, it may borrow from the Fed.  If you feel uncomfortable carrying around a lot of cash, you might deposit some of that cash in your bank account. If a bank feels uncomfortable having a lot of cash in its vault, it may deposit some of that vault cash in its account at the Fed.

Facts about the Fed 1. There are 12 branches of the Fed located in major cities throughout the nation. This makes it convenient for banks and other depository institutions to do their banking.

Facts about the Fed 2) The main headquarters of the Fed is in Washington D.C. 3) The President of the United States appoints the seven members of the Board of Governors of the Federal Reserve System. 4) The President also appoints one of the members to be the chairman of the Board of Governors and another member to be the vice chairman. 5) All the members of the Board of Governors serve 14-year terms. 6) The Board of Governors makes the important decisions concerning the money supply. Should the amount be increase? Decreased? Hold steady? (They have lots of ways to accomplish this, as we’ll see.)

New Fed Chairperson

The Fed The FED is a quasi-governmental institution. Not part of the executive, legislative, or judicial branches of government. Makes decisions concerning the money supply in complete autonomy. The FED is not responsible to the President or Congress, although it regularly reports to both on its operations and intentions for the money supply.

Fractional Reserve Banking Banks keep only a fraction of the money deposited on hand. Most of any given deposit is used to make loans or other investments. (Banks still keep plenty of money on hand to meet withdrawal needs.)

Required Reserves The FED requires all depository institutions (banks, credit unions, etc.) to keep 10% of deposits in reserve. Banks can hold their required reserves in their vault or in their account at the FED (by the way, currency held in a bank’s vault is not counted as part of the money supply…money in accounts does count.) These reserve requirements help the FED control the money supply (we’ll see how in a bit.)

The Money Expansion Process Imagine that a counterfeiter prints up $1000 in phony bills and spends the fake money at a jewelry store. The bank, not detecting the phony bills, credits the jeweler’s account by $1000. How much must the bank hold aside of this $1000 as required reserves? The remaining $900 can be used by the bank as they see fit (typically used to make loans or buy investments.)

The Money Expansion Process Now suppose the bank loans the $900 to someone applying for a home improvement loan. The $900 ends up being spent on paint. The owner of the paint store deposits the $900 into her account. Notice this $900 in her account is now part of the money supply (in addition to the original $1000 that is still in the jeweler’s account.)

The Money Expansion Process And this is not the end of the story. How much does the bank that received the $900 deposit from the paint store have to hold in reserve? The remaining $810 is excess reserves and the bank can use that money however they want. Suppose the bank buys some real estate as an investment with the $810 in excess reserves. Whoever sold the real estate to the bank now has a check for $810 to deposit into their account. Once this deposit takes place, the money supply has increased by an additional $810!

Money Expansion Process This just continues on and on. When all is said and done, the original $1000 in counterfeit money will have led to a $10,000 increase in the money supply.

How much will the money supply increase? Two formulas help us determine how much the money supply will increase because of a deposit from outside the system. 1 st Formula – Money Multiplier Formula Money Multiplier = 1/reserve requirement  E.g. Money Multiplier = 1/.10 = 10  This tells us that any deposit from outside the system (such as counterfeit money) will change the money supply by 10 times the amount of the deposit.

How much will the money supply increase? 2 nd Formula – Change in the Money Supply Change in the $ Supply = Money Multiplier x change in excess reserves (the amount the bank has to loan out…obviously not counting the required reserves) E.g. Change in Money Supply = 10 x $1000 = $10,000 If the reserve requirement was 5% and the counterfeiters deposited $4000 in fake money, the change in the money supply would be:  Money Multiplier = 1/.05 = 20  Change in Money Supply = 20 x $4000 = $80,000

Policy Tools of the Federal Reserve To adjust the money supply, the Fed can utilize the following methods: 1. Adjust the reserve requirements for depository institutions (i.e. banks, credit unions, etc.)  If the reserve requirement is lowered, banks have more money to loan/invest.  The money expansion process would kick in and the money supply would increase.  To decrease the money supply the Fed would raise reserve requirements.

Policy Tools of the Fed 2. Adjust the discount rate:  The discount rate is the rate of interest the Fed charges when it makes loans to banks and other depository institutions.  The Fed charges banks a rather low rate of interest on the loans it makes to banks (that’s why it’s called the “discount rate”)  If the Fed lowers the discount rate, more banks are encouraged to borrow.  The more banks barrow, the more they have to loan/invest, and the amount of money in circulation increases.  If the Fed wants to increase the money supply, it lowers the discount rate. If it wants to decrease the money supply, it increases the discount rate.  *During the recent financial crisis the Fed made loans to non- depository institutions for the first time. This allowed them to make loans to other troubled financial institutions.

Policy Tools of the Fed 3. Buy or sell government securities (aka “Quantitative Easing”):  Government securities are IOUs the government issues when it borrows money (aka Treasury bills/bonds/notes.) This includes the amount borrowed plus an interest rate.  The US has already sold trillions of dollars worth of Treasury bonds to individuals, corporations, and foreign governments.  Imagine what happens when the Fed buys some of these Treasury bonds back: The Fed pays the seller with a check that the seller deposits in a bank account. This deposit comes from outside the current money supply (just like with the counterfeiter) Therefore the money supply will increase by a multiple of this new money deposited in a bank (remember the 2 formulas we looked at earlier.)

Policy Tools of the Fed For example: If the reserve requirement is 10%, and the Fed wants to increase the money supply by $50 million, then the Fed would buy $5 million worth of Treasury bills.  Money Multiplier = 1/Reserve Requirement  Money Multiplier = 1/.10 = 10  Change in the Money Supply = Money Multiplier x Change in excess reserves  Change in the $ Supply = 10 x $5 million = $50 million  If the Fed wants to decrease the money supply, it would sell Treasury bonds

Summary: Policy Tools of the Fed ToolDescriptionTo Increase the $ Supply To Decrease the $ Supply Change reserve requirements Change the percentage of each deposit that banks must hold aside Lower the reserve requirement Raise the reserve requirement Change the discount rate Change the rate of interest the Fed charges on bank borrowings Lower the discount rate Raise the discount rate Buy/sell government securities Buy or sell Treasury bonds Buy Treasury bonds Sell Treasury bonds

What’s the current monetary policy of the US? Current Reserve Requirements: Amount in depository institution 10% required to be held in reserve $0-$13.3 million0% More than $13.3 million to $89 million 3% More than $89 million10%

What’s the current monetary policy of the US? Current Discount Rate 0.75% (Historic lows…e.g. 14% in 1980 to combat double digit inflation)

What’s the current monetary policy of the US? Current Purchases of Government Securities (QE): Fed buying $85 billion/month in Treasury bonds